Capital Requirements, Disclosure, and Supervision in the European Insurance Industry

New Challenges towards Solvency II

M. Starita, I. Malafronte

• Publisher: Palgrave Macmillan
• Year: 2015
• ISBN:
  9781137390844
• Topic: Betriebswirtschaft
• Subtopic: Finanzielles Risikomanagement

Capital Requirements, Disclosure, and Supervision in the European Insurance Industry provides an in-depth analysis of Solvency II's issues by combining both a theoretical approach and evidence of the empirical implications and effects on the European insurance industry.

1

Introduction

The aim of this chapter is to introduce and address the main issues that are discussed in each chapter of this manuscript. This chapter has five goals:

•identifying the main ‘Solvency II drivers’ and the main characteristics of the European insurance industry;

•introducing the risk-based approach to derive the new capital requirement for European insurers;

•describing the main ways in which control can be exercised within the insurer’s risk management framework by the insurer itself, and on the insurer by the supervisor according to a risk-based approach;

•identifying the market discipline process and the role of supervision under the Solvency II Directive;

•presenting the approach to disclosure consistent with the Solvency II third pillar requirements.

1.1 Solvency II Directive and the key features of the European insurance market

Solvency II is a broad project of the European Commission for the market of insurance services that started in 2003. Directive 2009/138/EC, the so-called Solvency II Directive, comes into force in 2016. The aim of this broad project is to rethink insurance activity, focusing on the risks taken by the insurer to safeguard the policyholders’ interests. It is clear that insurance activity is based on a risk portfolio, but it is not equally clear whether it is conducted according to a risk-based approach. Indeed, the adoption of a risk-based approach implies rethinking all procedures and processes within the insurer’s risk management system in the following manner: it is necessary to identify the effects of all procedures and processes on the risks taken by the insurer and on its solvency position. In so doing, each risk taken corresponds to a set of risk management practices and a capital buffer. To pursue this ambitious aim, the European Commission built a project based on a three-pillar structure.

The aim of this book is to serve as a ‘navigator’ to understand the new challenges for insurance companies inherent in the Solvency II project through the examination of its structure, the rules for compliance, and their implementation. The book is divided into three parts: the first part (Chapter 2) is dedicated to the description of the design of the Solvency II Directive and to the morphology of the European insurance industry. The second part (Chapters 3 and 4) analyses the new capital requirements and their supervision by the supervisor and the insurer itself. Finally, the third part (Chapters 5 and 6) analyses the challenges related to market discipline and voluntary disclosure. Each part presents theoretical issues, and provides data and empirical investigations on the topics analysed.

In this context, Chapter 2 identifies ‘Solvency II drivers’ and the main characteristics of the European insurance industry.

The objectives of the Solvency II project represent an articulated structure based on objectives of the first, second, and third order, and on three pillars (Section 2.1). The objectives of the first order are general: enhancing the protection for policyholders and beneficiaries by deepening the integration of the European insurance market, improving the international competitiveness of European insurers and reinsurers, and promoting better regulation as pursued by the European Union. The objectives of the second order are specific: from the insurer’s perspective, improving the risk management of EU insurers and reinsurers, and providing for a better allocation of capital resources; from the supervisor’s perspective, advancing supervisory convergence and cooperation as well as promoting international convergence and encouraging cross-sectorial consistency. All of these efforts lead to an increase in transparency. The objectives of the third order are operative: from the insurer’s perspective, harmonising the most important ‘solvency driver’, that is, the calculation of technical provisions, and to also introduce risk-sensitive and proportionate capital requirements for small insurers; from the supervisor’s perspective, harmonising supervisory powers, methods, and tools as well as supervisory reporting to ensure efficient supervision of insurance groups and financial conglomerates. To accomplish these aims, it is necessary to codify and recast all of the existing 13 insurance directives. It is possible to promote consistency between the prudential supervision of insurance and banking as well as compatibility with international accounting standards as elaborated by the International Accounting Standards Board (IASB) and the actuarial standards of the International Actuarial Association (IAA). The three-pillar structure can be considered to be the transformation of Solvency II objectives into a set of requirements. The first pillar consists of the quantitative requirements, which are the solvency capital requirement (SCR), the minimum capital requirement (MCR), and the rules to calculate the technical provisions and the portfolio of assets that cover technical provisions. The second pillar represents the qualitative requirements, which relate to the supervision of the relationship between the risk profile and the capital necessary to satisfy solvency needs by the supervisor through the SRP and by the insurer itself through its risk management policy and its own risk solvency assessment. Finally, the third pillar is based on market discipline requirements to communicate the quantitative and qualitative requirements through supervisory reporting and public disclosure. The implementation of the three pillars will have a great impact on the insurer’s risk management practices: Chapter 2 also attempts to identify the incentives to adopt best practices for large insurers as well as for small insurers.

The analysis of the primary characteristics of the European insurance industry is based on data that are obtained from ‘Insurance Europe’, which is the voice of the European insurance industry at the European and international level. The analysis is based on the description of the life insurance business, the non-life business, and the entire business in terms of premiums, benefits/claims, and investments. From this perspective, it is important to underscore the relationship between the insurance industry and economic development (Section 2.2).

After analysing the European insurance industry, Chapter 2 identifies a set of insurers that represent the sample to test the topics analysed in the empirical section of each chapter, more specifically in Sections 3.3, 4.3, and 6.3 (Section 2.3).

1.2 The solvency capital requirement

The aim of Chapter 3 is to explore the new capital requirement to clearly understand the opportunities and threats linked to its implementation.

The new capital requirement for European insurers is called the SCR, which is derived through a risk-based approach. This approach is based on the following:

•the principles to re-assess the SCR components according to the solvency purposes: these components are technical provisions and assets covering technical provisions as well as other liabilities and own funds;

•the distinction between quantifiable and non-quantifiable risks: the former are risks for which it is possible to identify and measure their probability and impact, while the latter are risks for which it is not possible to clearly identify their probability and impact; the SCR must cover all quantifiable risks undertaken by the insurer;

•the identification of risk mitigation mechanisms: these are risk mitigation techniques, such as reinsurance arrangements, and other mechanisms, such as correlations among risks and sub-risks, diversification effects between entities in the same group or financial conglomerates, the loss absorption capacity of technical liabilities themselves, and the use of the discretionary benefits and of the deferred taxes;

•the Value-at-Risk (VaR) technique: the SCR must correspond to the level of the distribution of own funds at a low level of default (that is 99.5%) over one year.

To calculate the SCR, the European Commission identifies two models: a standard formula and an internal model. The assumptions of the standard formula are identified by the European Commission; this model is addressed to insurers that are not able to provide own assumptions to re-assess the SCR components. The internal model is based on assumptions that are strictly related to the insurer’s risk portfolio characteristics; thus, the assumptions of the internal model must be validated by the supervisor. However, each insurer’s risk management framework must justify the correspondence between the model chosen and the risks undertaken by the insurer: any lack of correspondence must be justified or covered by a capital injection.

Section 3.1 is devoted to an analysis of the SCR components and a description of the standard formula.

The re-assessment of assets and other liabilities must use a market consistent approach that implies the use of a mark-to-market technique, if possible. If it is not possible to use mark-to-market, it is necessary to apply a mark-to-market technique using data pertaining to similar assets/liabilities, if possible. If this approach is not possible, it is necessary to apply a mark-to-model technique using data from the market.

The re-assessment of technical provisions is based on a market consistent approach as defined by the European Commission; according to this approach, it is necessary to hypothesise all possible scenarios for technical provisions in addition to a transfer scenario. The component identified in the correspondence of all possible scenarios is defined as the ‘best estimate’, that is, the average of the outcomes of all possible scenarios weighted by their respective probabilities while accounting for the time value of money. The component identified in correspondence with the transfer scenario is called the ‘risk margin’; this component ensures that the value of the technical provisions is equivalent to the amount that the insurer would be expected to require to satisfy its insurance obligations.

The analysis also includes the element to cover the SCR, that is, the own funds. To protect the interests of policyholders and the beneficiaries of insurance obligations, the own funds are grouped into tiers: Tier 1 is the most important element necessary to cover the SCR.

The calculated SCR covers the following quantifiable risks according to the standard formula: the underwriting risk for life, non-life, and health business, the credit risk, the market risk, the risk linked to intangible assets, and the operational risk. According to a modular approach, each risk is divided into a set of sub-risks, and the process of aggregating the SCR for each risk is based on the correlation between each sub-risk and each other. At the same time, the overall SCR is based on the correlation between each risk and all of the others. The process of aggregation accounts for the loss absorption capacity of technical liabilities, such as the capacity to absorb unexpected losses through reducing the tax burden or cancelling the discretionary benefits distribution plan; discretionary benefits are benefits beyond the guaranteed benefits. In summary, it is clear that the SCR is very similar to the concept of economic capital.

Section 3.2 is devoted to identifying the function of the minimum capital requirement. If the SCR is sufficient to face all the requests of policyholders and beneficiaries of insurance obligations, the MCR can be considered to be a special level of the SCR because its breach triggers supervisory intervention. The MCR is, therefore, the most important safety measure. The approach to deriving the MCR is a combination of simplicity in calculation and consistency with the SCR.

Finally, Section 3.3 provides an empirical analysis of the SCR and the MCR for the sample identified in Chapter 2. It is clear that it is very difficult to provide an estimation of the SCR and the MCR because it is necessary to have very granular data on the risk portfolio. To overcome these obstacles, the section provides a set of hypotheses and the stress scenarios necessary to calculate the SCR under the standard formula, focusing on underwriting risk for life and non-life business.

1.3 The supervision of insurance companies

The aim of the Chapter 4 is to describe the ways in which control can be exercised within the insurer’s risk management framework by the insurer itself and on the insurer by the supervisor according to a risk-based approach. These two perspectives of control must be interconnected and based on the risks taken by the insurer in the interests of the policyholders and beneficiaries of the insurance obligations. Usually, control of the risk portfolio is the most important task performed by the risk management framework of each insurer; according to the risk-based approach, this control should create a direct correspondence between the risks taken by the insurer and risk management practices. This correspondence should, in turn, create a direct relationship between the set of risk management practices activated and the capital absorption as well as the solvency position. The creation of these levels of correspondence can be considered to be a necessary condition for easy communication with the supervisor under its continuous control.

Section 4.1 analyses control within the insurer from three different but interconnected perspectives. The first is the internal control perspective: the focus of internal control is on the adequacy of the processes and procedures given the risks taken by the insurers; the processes adopted to derive the assessment of technical provisions are also under the control of the actuarial function. The second is the risk management perspective: control as performed by the risk management framework is relative to all quantifiable and not-quantifiable risks taken by the insurer, which means that the insurer identifies a set of policies to address the primary issues related to risk management. In this framework, control over the correspondence between the level of risks taken and risk tolerance is crucial to pursue sound and prudent risk management. Finally, the investment and asset-liability perspective is the third and the focus of the control executed by investment and asset-liability management (ALM) activities is on assets, covering technical provisions, and research to find an equilibrium between the determinants of the portfolio of insurance obligations and the characteristics of the portfolio of assets. The research of this equilibrium can be achieved through the pursuit of the Prudent Person Principle (PPP). The PPP is a set of simple rules to follow in the construction and management of the portfolio of assets, covering technical provisions.

Section 4.2 provides for an in-depth analysis of the control exercised on the insurer by the supervisor according to the second pillar of Solvency II. According to the risk-based approach, the supervisor must review, rather than control, the ways in which the insurer controls and manages its risk portfolio. This approach means that the supervisor has a set of procedures and instruments available to control the insurer’s activity on a continuous basis. The most important procedure is the Supervisory Review Process (SRP); it is the overall review conducted by the supervisory authority to ensure insurer compliance with the law, regulations, and administrative provisions. A special aspect of the SR...